How will automation affect investing?

Specialist Frank Masiello, right, works with traders at his post on the floor of the New York Stock Exchange, Tuesday, July 28, 2015. More and more firms have been adapting automative technology to streamline investing.

The 19th-century ballad of folk hero John Henry’s epic attempt to outwork a steam-driven railroad machine is a parable of the disruption and job loss that often follow productivity-enhancing innovation. Advancements in manufacturing ushered in enormous increases in productivity during the Industrial Revolution. The gains of the Internet era are no less impressive — and no less disruptive. The list of industries that have been upended by digital innovation is long and growing.

The financial planning and full-service investment management industry was able to adapt to the threat posed by the scores of brash DIY brokerage and Internet trading platforms that began sprouting up in the 1990s. To a degree, the financial services industry’s ability to stave off this wave of lower-cost online trading alternatives was facilitated by the two major bear markets of early 2000s. Those downturns helped people realize the ridiculousness of the suggestion that every pimply-faced teenager could effortlessly day-trade his way to his own personal helicopter. By the stock market nadir of 2009, it was eminently clear that stock trading was not a path to easy riches for most American investors, and that the market for day trading was limited to a small segment of hardcore do-it-yourselfers. Ironically, to stave off their own extinction, the upstart DIY brokerage firms shifted their models to providing their trading platforms and clearing and custody services to registered investment advisory firms.

Within the past couple of years, however, an entirely new competitor has emerged that may truly pose an existential threat to the traditional financial planning and investment advisory models —the automated advisory platform, or “robo-advisor.” Robo-advisor operators say they will disrupt and perhaps displace the role of the traditional financial advisor; support for this assertion can be found in the hundreds of millions of dollars of venture capital backing the early entrants into this space and in the billions of consumer dollars pouring into these platforms. It can also be found in the knee-jerk defensive response of some of the original DIY brokerage firms to roll out their own robo-advisor platforms, since their clients, too, are in the robo-advisors’ sights.

Sophistication under the hood

Similar to the online brokerages, the typical robo-advisor aims to attract investor assets by pairing ultra-low fees with a sleek, intuitive user experience. What sets the robo-advisors’ value proposition apart — and what has many financial advisors fearing for their livelihoods — is that they feature sophisticated investment advice and portfolio management algorithms that are beyond the capabilities of most full-service professionals. In short, they promise to provide better, more sophisticated advice.

Consider the two first-to-market players in this space, Wealthfront and Betterment. Both feature extremely sophisticated portfolio models that employ low-cost index funds and ETFs as the underlying investment instruments. Wealthfront’s models seek to enhance returns through a tax-efficient trading strategy developed by a team of elite academic researchers headed by renowned Princeton economist Burton Malkiel. Betterment employs its own heady team of quants to oversee its implementation of the Black-Litterman portfolio optimization model. Even if the average investment rep or financial planner had the academic background and sophistication to understand these investment strategies, it would be virtually impossible to implement them at the individual account level.

Thus, a primary and decidedly compelling benefit of the robo-advisor concept is that it brings erudite, disciplined, previously inaccessible investment management to the masses. That does not necessarily eliminate the need for the traditional financial advisor. Indeed, a flaw with some of these early entrants is that empirically supported trading strategies may not jibe with the real-world objectives of flesh-and-blood investors. For instance, Betterment’s dynamic withdrawal strategy, which promises to ensure lifetime income sustainability, requires retirees to adjust their income each year, depending upon market conditions and performance. Retirees who were accustomed to gradually rising wages throughout their working lives may be reluctant to embrace a strategy that requires them to reduce their incomes in certain years.

Indeed, if there is an Achilles’ heel in the investment models of the current generation of robo-advisors, it may be that the withdrawal strategies promoted thus far may still be out of touch with real-world consumer objectives and spending behavior. Additionally, the 1998 failure of the massive hedge fund Long Term Capital Management, as chronicled in Roger Lowenstein’s best-seller “When Genius Failed,” serves as a potent cautionary reminder of the danger of placing too much faith in academic theory and fail-proof trading concepts.

Some will be threatened, but not all

Nonetheless, for financial advisors who predicate their business on their investment acumen and their abilities to generate market-beating returns, the competitive threat posed by the robo platforms seems analogous to the ill-fated showdown between John Henry and his indomitable automated nemesis. To borrow a line from the classic 1986 horror movie “The Fly,” traditional investment-based financial advisors today should “be afraid — be very afraid.”

Whether the rise of automated advisory platforms poses a similar existential threat to advisors who provide more comprehensive planning services and guidance is more difficult to assess. To be sure, the robo army aims to take their lunch money, too. Given that computers have been programmed to outsmart chess grandmasters and “Jeopardy” champions, it would seem that the smart money should be placed on the robos. However, while decision rules in chess may be boiled down to math and massive processing capabilities and “Jeopardy” may be boiled down to the programming equivalent of “20 Questions” and lightning-fast search capabilities, the interactive nature of the planning process and the subjective nature of the advice game may prove the elite financial planner a surprisingly formidable adversary for the robo-advisor.

Far from being threatened by the sophistication of automated investment platforms, planners whose practices are based on providing objective, comprehensive planning advice may actually embrace the efficiency of the robo-advisor models. Such planners may take on the role of evaluating the different advisory platforms based upon their abilities to add value over a traditional portfolio of low-cost index funds, as well as relative to one another.

Additionally, while robo algorithms may outperform the human planner in tasks such as “memorizing” the entire Internal Revenue Code and every state and federal statute pertaining to estate planning law, the robo-advisor’s inability to deal with subjective issues and matters that require human interaction may confound programming logic. For instance, it seems unlikely that an algorithm will be designed that will be able to assist and educate a client in navigating the complexities of the college admissions and financial aid planning process; that will gather and review the appropriateness of the client’s various asset registrations and beneficiary designations; or that will go through clients’ employee handbooks to make sure they are maximizing their benefits. Such quintessential financial planning services offer real, tangible value that is often every bit as important as sound investment management. The subjective, interactive nature of these services — and of the client-planner relationship in general — simply does not lend itself well to impersonal, decision-based automation.

Technical limits pose opportunity

This limitation seems to have been tacitly acknowledged already, as a handful of robo-advisors, including FutureAdvisor, Personal Capital and Vanguard, are trying to address the need for human interaction in the planning process by pairing their automated platforms with low-cost one-on-one access to live financial professionals. However, DIY brokerages have been assigning flesh-and-blood financial reps to individual clients for years, and this has never posed any significant threat to the financial planning community.

It takes many hours of personal interaction for a planner to gather enough information from a client to thoroughly understand that person’s objectives and experience. Trying to duplicate this labor-intensive effort in a business model that operates on razor-thin margins — and that depends upon low pricing being offset through scale — seems like it would be a profitability-killer for the robo-planner concept.

In conclusion, it seems clear that the rise of automated investment platforms presents a very real threat to the livelihoods of traditional investment-oriented financial advisors, but that advisors who offer more comprehensive planning guidance may not only survive, but benefit from the innovation. While the pace of change in the information age may seem to be accelerating, the Darwinian nature of the financial services industry (and capitalism in general) is hardly new. As always, the rules are “adapt or perish” and “survival of the fittest.”

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